Pref Equity

Some pref's are set up that the first i.e. 9% are distributed to the LP some are Pari Passu where the first 9% is split to the operating partner and the lp pro rata. While technically not a real pref, more like a first hurdle. While there is a number of ways I was wondering what would typical of a transaction of this simplicity.

I might just do 1st hurdle "pref" with a binary switch from data validation and an option for 50/50 split on the residual.

Gentleman and Scholar:

The 2nd way I have underwritten pref equity is what I would call "synthetic debt." The preferred equity behaves like mezz debt, and you make monthly payments and capitalize any interest / operating deficit caused by the additional debt burden.

Yeah, nobody has given me guidance as to how to underwrite it so I have to wing it. I had figured to structure it like mezz wit the accrue rate being the pref rate so any missed payments of pref would acrue at the pref rate until the capital/exit event. Or common equity would need to add capital or equity infusion in a year. This is for a stabilized product so should be ok.

Does this sound right?

Yes, you technically could but there is a couple reasons why this wouldn’t make sense as a capital stack structure.

Pref equity typically carries higher pricing as you touched on before (12-15% carry rates) so any deal structured with that interest rate on 60-80% of value of likely economically unsustainable and the LP would see hardly any return.

GP is usually the managing partner and as such, smart LPs want incentives aligned. Most GPs charge acquisition and asset management fees so in a 95/5 split the GP has got most of their money back at the close and has limited skin in the game. A 95/5 split happens but is usually reserved for partners you are really comfortable with or have proven can very reliably produce returns in that specific asset class.

One key difference I've seen between the two... Mezzanine acts as a true debt facility. That is, principle & interest payments over the life of the loan (although many are structured as interest-only). Payments are due on time, just like any other loan, with penalty for missing your due date. Preferred equity interest can be left unpaid and will accrue until it get's taken out by sale or refinance. Therefore, you can capitalize the deal with preferred equity and never make a payment until your balloon is due.

We're working on a development deal right now that is capitalized with a senior construction loan, preferred equity slug, and rounded out with common equity. The preferred investor could have either lent through a mezz facility, or taken the pref position - both would have the same subordination to the construction loan and similar risk in that regard.

The reason the GP went with a more expensive preferred equity investment is because the deal will throw off little to no cash flow in the short-term (construction, lease-up, etc.), meaning you can't service the mezzanine debt and must capitalize carried interest upfront. They were confident that the deal would sell for a big enough number to "catch-up" the preferred interest that they don't have to pay, but accrued.

General rule of thumb on price: Mezzanine charges 8%-10%, Pref is somewhere around 12%-15%.

Long winded, I know. Let me know if this doesn't make sense.

Post hoc ergo propter hoc:

and regarding pricing on mezz vs pref to the above post I think that's about right -- It's been a few months since I've gotten a hard quote/term sheet, and granted it was in a Tier II market (Nashville, Charlotte, etc.)...but our mezz was slightly more expensive.

And regarding the point about never having to pay out a dollar to the pref until balloon, I've seen yes and no to that. Obviously no pref investor would be happy in that scenario, and sometimes there are "accrued rates" that are very steep to protect them against that. On the Mezz side, the hidden gut punch I've seen is the usage of "current" and "accrued" interest. When you take the blended WTD AVG rate, our deal was 15%-18%...obviously a complete non-starter in this environment. What I mean by accrued interest is that there is a smaller current interest rate that gets paid monthly. But then there is an accrued rate that compounds by being tacked on to the principal. At maturity, you owe the original principal PLUS all of the accrued interest. Again, this was just plain excessive and made the returns almost laughable.

It's an obvious question -- why would anyone actually strike at those rates with all the other options out there? I thought the same thing until I did a couple deals with small shops and investors. Not everyone has a direct line to a large lifeco or bank lender senior VP. Some people are sitting on land, and looking down the barrel of escalating costs, repricing of the GC or losing the deal altogether. In that light, a mezz lender sometimes is the only option to get the deal done...

The mezz structure that accrues interest on top of the ending balance of principal at the end of each period is "PIK interest" correct?

Some points on the “why would anyone use mezzanine debt when pricing is so high?”.

• Low rate environment keeps initial leverage low

• Pricing seems high but it’s only a small slice of the capital stack

• If additional leverage is the difference between a developer doing one or multiple deals, they will take the additional debt most of the time

• If it is a construction deal, mezzanine debt can often be drawn towards the end of the construction so it will not be outstanding long

Banks during this cycle have stayed relatively conservative and are only underwriting loans to about 65% loan to cost (LTC). So a typical capital stack would look like this:

$100 project cost $65 acquisition and development (A&D) loan $31.5 limited partner equity (LP) at 90% split $3.5 general partner equity (GP) at 10% split

If you are a smaller developer and that is millions of dollars, you might have trouble coming up with that capital requirement. So you explore mezzanine and pricing comes back at 15-18% but it will get you up to 85% LTC, so your capital stack looks like this:

$100 project cost $65 A&D loan $20 Mezzanine loan $13.5 LP equity at 90% split $1.5 GP equity at 10% split

So now as the developer (GP), I can do almost three similar deals and depending on the project I might only have drawn on the balance of that mezzanine loan for 3-6 months depending on how quickly you exit. Additionally the higher pricing and interest costs are shared by the partnership. Not that bad of an arrangement from the developer’s point of view.

In addition to this, pref helps round out the capital stack for deals where a GP does not want to split the perceived upside with an LP in development projects. Pref is treated as equity for HVCRE purposes, so it is a way around that issue when procuring construction financing from banks, with minimal common equity in the deal. Mezz is debt and is excluded from the equity tally for HVCRE purposes.

Not true. Pref equity can be structured in an infinite number of ways, including participating preferred. So while it generally does not benefit from a waterfall style promote, it can snatch a chunk of the net proceeds/upside at sale before the rest of the cash flows go through the true equity waterfall and are divvied up by the GP + LP.

Mezz and Pref are used interchangeably because, at the end of the day, the key difference is exactly what you pointed out - mezz has stronger protections and can easily foreclose in a default scenario while pref has laxer downside protections and a longer path to the keys. The structure of the cash flows is not what defines mezz vs. pref, its the RIGHTS in a downside scenario. Basically, the borrower has more remedies and time to right the ship. I'm not well versed in the technical aspects of the docs and right but hopefully, someone can shed more light on those.